Case study
Case Study: A Duplex Owner Runs the Numbers From Purchase to Sale
A Sacramento duplex bought for cash flow turns out to earn its keep three different ways — and almost none of it shows up as taxable income. Ten years of depreciation, one repairs-vs-improvements fight with a water heater, and the sale math that surprises everyone the first time.
8 min read · Published September 2026
Key Takeaways
- A rental can pay you three separate ways at once — cash flow, mortgage principal paydown, and appreciation — while the tax return only ever sees a fraction of it, because depreciation and deductible mortgage interest shrink taxable income independently of cash in the bank.
- Depreciation ($300,000 building ÷ 27.5 years ≈ $10,909/year) is large enough to push taxable income to roughly zero in the early years of ownership even while monthly cash flow is solidly positive.
- A safe harbor election, not a facts-and-circumstances judgment call, decided whether a $2,200 water heater was a same-year deduction or a 27.5-year capital item.
- "Capital gains, 15%" is not what a rental sale actually owes — depreciation taken over the years comes back first, taxed separately and at a higher rate.
- California taxes the entire gain as ordinary income, with no preferential rate for any part of it, which is often the single largest layer in the whole stack.
- A 1031 exchange defers the entire tax bill calculated below rather than reducing it — which makes it a timing decision, not a way to make the numbers smaller.
The numbers below are run through this site’s own calculators, not estimated by hand. The owner is a composite, not a real client — this site isn’t attached to a firm and doesn’t have any.
The purchase, 2016
Priya bought a duplex in Sacramento for $400,000 — $100,000 of that allocated to land, $300,000 to the building, based on the county assessment. She put 25% down ($100,000), paid $8,000 in closing costs, and financed the remaining $300,000 at 4.5% over 30 years. She bought it, in her own words, “for the cash flow.”
About $500 a month landed in the checking account after every bill was paid, including the mortgage. That's the number Priya was watching — and the smallest of the three ways this property was about to pay her.
Cap rate, cash-on-cash, and cash flow each answer a different question about the same deal; see the full breakdown before treating any one of them as “the” return.
The ownership years: earning it three ways, on paper once
A rental like this one pays its owner three separate ways at once: the monthly cash flow above, the slice of every mortgage payment that pays down principal instead of interest, and whatever the property appreciates in the background. The tax return sees almost none of that, because depreciation — $300,000 ÷ 27.5 years ≈ $10,909 a year — is subtracted before arriving at taxable income, and it costs Priya nothing in cash.
Cash flow that same year was positive, about $5,960. Depreciation stays flat every year while the mortgage's interest portion shrinks as the loan amortizes — so a few years in, taxable income drifts from roughly zero to modestly positive even with rent unchanged, the same mechanics running in reverse.
The duplex paid Priya three ways — cash flow, principal, and appreciation — and the tax return only ever found out about one of them, and not even the true size of that one.
The water heater, year six
One of the duplex’s two water heaters failed and was replaced for $2,200. Priya’s bookkeeper, working from the general rule, wanted to capitalize it as a restoration to the plumbing system and depreciate it over 27.5 years — about $80 a year for the next three decades.
The invoice came in under the $2,500-per-item de minimis threshold, so the election converted a three-decade trickle into a single-year deduction. Nothing about the water heater changed — only which side of an annual election it landed on.
The full rule for telling a repair from an improvement — including the two other safe harbors and what happens when none of them apply — is its own article, and it’s worth reading before the next major system fails.
The sale, 2026: “capital gains, 15%”
Ten years in, the duplex is worth about $700,000. Priya’s working assumption going into the sale was simple: capital gains, 15% federal, done. The actual stack has four layers, and the depreciation she was glad to claim every year shows up first, taxed the hardest.
The $109,000 of depreciation she deducted over ten years doesn't disappear from the math — it comes back here, as part of a larger gain than a simple 'sale price minus purchase price' guess would produce.
| Layer | Amount taxed | Rate | Tax |
|---|---|---|---|
| Unrecaptured §1250 gain (depreciation) | $109,000 | 25% federal | $27,250 |
| Remaining long-term gain | $258,000 | 15% federal | $38,700 |
| Net investment income tax | $367,000 | 3.8% | ≈ $13,950 |
| California (ordinary income, no preferential rate) | $367,000 | 9.3% marginal | ≈ $34,100 |
That’s about $114,000 total — roughly 31% of the gain, and more than double the $55,000 Priya’s “15%” assumption would have produced. Depreciation recapture and the California layer account for most of the gap; see the full line-by-line breakdown this case study draws from, and why California skips the preferential rate entirely.
A 1031 exchange defers this stack — it doesn't shrink it
Priya hasn’t decided. Selling outright means writing a check for about $114,000 and being done with landlording. A 1031 means no check now, a replacement property to find on a deadline, and the same tax question waiting at the next sale instead of this one. She’s running both scenarios through the numbers before choosing — which is the only honest way to make this decision, and the reason there isn’t a tidier ending here.
See what a 1031 exchange actually defers
Enter the sale price, basis, and a replacement property.
Run your own rental’s cap rate, cash flow, and taxable income
Same calculator behind every number in this case study.
You might also read
Rental Property Returns Explained: Cap Rate, Cash-on-Cash, and Cash Flow
Three numbers describe what a rental actually earns, and they answer three different questions — what the property yields, what your invested cash yields, and what hits your bank account each month. None of them is the number that lands on your tax return, and the gap between them is where most rental math goes wrong.
Real estate & rentalSelling a Rental Property: The Full Tax Bill, Line by Line
The tax on selling a rental isn't one number — it's a stack: depreciation recapture at up to 25%, capital gain on the rest, the 3.8% NIIT on top, and California taxing all of it as ordinary income. Here's the whole stack computed on one sale, and the two exits that defer or erase it.
Real estate & rentalRepairs vs. Improvements: What Landlords Can Deduct Now vs. Must Capitalize
Fix a leaking faucet and it's a same-year deduction. Replace the whole plumbing system and it's a capital improvement, depreciated over decades. Three safe harbors and a three-part test decide which side of the line a given repair bill lands on.
Frequently asked
Questions owners actually ask
- Is this a real duplex owner?
- No — the numbers below are illustrative, run through this site's own calculators. There's no firm behind this site and no client relationship being described.
- How can taxable income be near zero if the property paid her $500 a month?
- Because taxable rental income and cash flow are computed from different subtractions. Cash flow is rent minus operating expenses minus the full mortgage payment (principal and interest). Taxable income is rent minus operating expenses minus only the interest portion of the mortgage, then minus depreciation — a deduction that costs no cash at all. Depreciation alone was larger than the gap between the two numbers here.
- Why does depreciation come back at 25% instead of the 15% capital gains rate?
- The portion of the gain equal to depreciation already claimed is unrecaptured section 1250 gain, and it's taxed at a maximum federal rate of 25% — higher than the 0/15/20% long-term capital gains rates that apply to the rest of the profit. The logic: that slice of the gain was never really appreciation, it was the IRS collecting back a deduction it let her take early.
- Why does California tax all of it as ordinary income?
- California has no separate capital gains rate at all — a long-term gain is taxed exactly like wages, on the same 1% to 13.3% bracket schedule. It doesn't distinguish depreciation recapture from appreciation the way the federal return does; the whole $367,000 gain in the example below is just income to the state. See the full breakdown in the California capital gains article.
- What made the water heater a repair and not a capital improvement?
- The invoice, at $2,200, fell under the $2,500-per-item de minimis safe harbor — an annual election that lets a taxpayer deduct smaller purchases immediately instead of running them through the betterment/restoration/adaptation test. Without that election, replacing a plumbing system's major component is ordinarily a capitalized restoration, depreciated over 27.5 years instead of deducted in one year.
- Should she do a 1031 exchange instead of just selling?
- That depends on facts this case study doesn't have — mainly whether she wants to keep owning rental real estate at all, and whether a suitable replacement property exists inside the exchange's tight 45- and 180-day deadlines. A 1031 defers every dollar of tax calculated below; it doesn't eliminate any of it, and the deferred gain and recapture simply transfer onto the new property's basis. It's worth running the actual replacement deal's numbers before deciding either way.
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Educational content only. This article is for informational purposes and does not constitute tax, legal, or financial advice. Every situation is different — consult a qualified professional before acting on anything here.